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This chapter applies your knowledge of cost and revenue behavior, obtained in the previous chapters, to a variety of operating

decisions. The framework for such decisions includes the following fundamental concepts:

Differential costs and revenues: The costs and revenues that are relevant to a specific decision are those that differ as a consequence of the decision. You have seen this concept earlier, in deciding among alternative cost functions.

Sunk costs: The irrecoverable costs incurred in the past are usually not relevant in making decisions that affect future costs and revenues. In some cases, sunk costs may be relevant if they affect the way that managers performance is measured.

Opportunity costs: Opportunity costs represent the benefits foregone from alternative uses of resources. A rational decision maker attempts to minimize opportunity losses, which is the same as maximizing profits.

Information accuracy: A central issue in the use of estimated costs and revenues is the amount of error in the estimates that will cause the manager to make a costly mistake. This issue is usually described as the sensitivity of a decision to changes in estimates or assumptions.

Avoid arbitrary allocations

of costs and benefits (e.g. joint cost allocations).

Special Order Decisions A new customer (or an existing customer) may sometimes request a special order with a lower selling price per unit. The general rule for special order decisions is:
accept the order if incremental revenues exceed incremental costs, subject to qualitative considerations.

If the special order replaces a portion of normal operations, then the opportunity cost of accepting the order must be included in incremental costs.

Special Order Decisions


RobotBits, Inc. makes sensory input devices for robot manufacturers. The normal selling price is $38.00 per unit. RobotBits was approached by a large robot manufacturer, U.S. Robots, Inc. USR wants to buy 8,000 units at $24, and USR will pay the shipping costs. The per-unit costs traceable to the product (based on normal capacity of 94,000 units) are listed below. Which costs are relevant to this decision? yes$6.20 Relevant? Direct materials yes 8.00 Relevant? Direct labor Variable mfg. overhead yes 5.80 Relevant? no 3.50 Relevant? Fixed mfg. overhead Shipping/handling 2.50 Relevant? Fixed administrative costs no 0.88 Relevant? no 0.36 Relevant? Fixed selling costs $27.24

$20.00

Special Order Decisions


Suppose that the capacity of RobotBits is 107,000 units and projected sales to regular customers this year total 94,000 units. Does the quantitative analysis suggest that the company should accept the special order? First determine if there is sufficient idle capacity to accept this order without disrupting normal operations: Projected sales to regular customers Special order 94,000 units 8,000 units 102,000 units

RobotBits still has 5,000 units of idle capacity if the order is accepted. Compare incremental revenue to incremental cost: Incremental profit if accept special order = ($24 selling price - $20 relevant costs) x 8,000 units = $32,000

Special Order Decisions and Capacity Issues


Suppose instead that the capacity of RobotBits is 100,000 units and projected sales to regular customers this year totals 94,000 units. Should the company accept the special order?

Here the company does not have enough idle capacity to accept the order:

Projected sales to regular customers Special order

94,000 units 8,000 units 102,000 units

If USR will not agree to a reduction of the order to 6,000 units, then the offer can only be accepted by denying sales of 2,000 units to regular customers.

Special Order Decisions and Capacity Issues


Suppose instead that the capacity of RobotBits is 100,000 units and projected sales to regular customers this year total 94,000 units. Does the quantitative analysis suggest that the company should accept the special order?

Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Shipping/handling Fixed administrative costs Fixed selling costs

$6.20 8.00 5.80 3.50 2.50 0.88 0.36 $27.24

Variable cost/unit for regular sales = $22.50. CM/unit on regular sales = $38.00 - $22.50 = $15.50.
The opportunity cost of accepting this order is the lost contribution margin on 2,000 units of regular sales.

Incremental profit if accept special order = $32,000 incremental profit under idle capacity opportunity cost = $32,000 - $15.50 x 2,000 = $1,000

Special Order Decisions and Capacity Issues


Alternative calculation: Revenues: Increase, special order sales, 8,000 units @24 Decrease, lost regular sales, 2,000 units @38 Costs: Increase, 6,000 units @ $20 Decrease, shipping costs saved, $2.50 per unit Net effect (benefit) $192,000 ( 76,000)

(120,000) 5,000 $ 1,000

Keep or Drop Decisions Managers must determine whether to keep or eliminate business segments that appear to be unprofitable. The general rule for keep or drop decisions is:
keep the business segment if its contribution margin covers its avoidable fixed costs, subject to qualitative considerations.

If the business segments elimination will affect continuing operations, the opportunity costs of its discontinuation must be included in the analysis.

Keep or Drop Decisions


Starz, Inc. has 3 divisions. The Gibson and Quaid Divisions have recently been operating at a loss. Management is considering the elimination of these divisions. Divisional income statements (in 1000s of dollars) are given below. According to the quantitative analysis, should Starz eliminate Gibson or Quaid or both?
Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Total $1,660 1,054 606 455 151 81 $70

Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166

$96 18 $114

$139 36 $175

Keep or Drop Decisions


Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Total $1,660 1,054 606 455 151 81 $70

Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166

$96 18 $114

$139 36 $175

Use the general rule to determine if Gibson and/or Quaid should be eliminated.

Contribution margin Avoidable fixed costs Effect on profit if keep

Gibson Quaid $143 $98 154 96 ($11) $2

The general rule shows that we should keep Quaid and drop Gibson.

Keep or Drop Decisions


Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Total $1,660 1,054 606 455 151 81 $70

Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166

$96 18 $114

$139 36 $175

Gibson Quaid Russell $390 247 143 166 ($23) $433 335 98 114 ($16) $837 472 365 175 $190

Total $1,270 807 $463 289 $174 81 12 $81

Quaid & Russell only

Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Gibson's unavoidable fixed costs Operating income

Profits increase by $11 when Gibson is eliminated.

Keep or Drop Decisions


Suppose that the Gibson & Quaid Divisions use the same supplier for a particular production input. If the Gibson Division is dropped, the decrease in purchases from this supplier means that Quaid will no longer receive volume discounts on this input. This will increase the costs of production for Quaid by $14,000 per year. In this scenario, should Starz still eliminate the Gibson Division?

Effect on profit if drop Gibson before considering impact on Quaid's production costs Opportunity cost of eliminating Gibson Revised effect on profit if drop Gibson

$11 (14) ($3)

Profits decrease by $3 when Gibson is eliminated.

Keep or Drop Decisions


Suppose that the Gibson & Quaid Divisions use the same supplier for a particular production input. If the Gibson Division is dropped, the decrease in purchases from this supplier means that Quaid will no longer receive volume discounts on this input. This will increase the costs of production for Quaid by $14,000 per year. In this scenario, should Starz still eliminate the Gibson Division?

Effect on profit if drop Gibson before considering impact on Quaid's production costs Opportunity cost of eliminating Gibson Revised effect on profit if drop Gibson

$11 (14) ($3)

Profits decrease by $3 when Gibson is eliminated. Question: In this case, should Gibson and Quaid both be dropped? Are they truly independent divisions?

Insource or Outsource (Make or Buy) Decisions


Managers often must determine whether to
make or buy a production input keep a business activity in house or outsource the activity

The general rule for make or buy decisions is:


choose the alternative with the lowest relevant (incremental cost), subject to qualitative considerations.

If the decision will affect other aspects of operations, these costs (or lost revenues) must be included in the analysis.

Make or Buy Decisions


Graham Co. currently manufactures a part called a gasker used in the manufacture of its main product. Graham makes and uses 60,000 gaskers per year. The production costs are detailed below. An outside supplier has offered to supply Graham 60,000 gaskers per year at $1.55 each. Fixed production costs of $30,000 associated with the gaskers are unavoidable. Should Graham make or buy the gaskers? The production costs per unit for manufacturing a gasker are: Direct materials $0.65 Relevant? yes 0.45 Relevant? Direct labor Variable manufacturing overhead yes 0.40 Relevant? no 0.50 Relevant? Fixed manufacturing overhead* $2.00 *$30,000/60,000 units = $0.50/unit Advantage of make over buy = [$1.55 - $1.50] x 60,000 = $3,000

Make or Buy Decisions


Suppose the potential supplier of the gasker offers Graham a discount for a different sub-unit required to manufacture Grahams main product if Graham purchases 60,000 gaskers annually. This discount is expected to save Graham $15,000 per year. Should Graham consider purchasing the gaskers?

Advantage of make over buy before considering discount Discount Advantage of buy over make

$3,000 15,000 $12,000

Profits increase by $12,000 when the gasker is purchased instead of manufactured.

Constrained Resource (Product Emphasis) Decisions


Managers often face constraints such as

production capacity constraints such as machine hours or limits on availability of material inputs limits on the quantities of outputs that customers demand

Managers need to determine which products should first be allocated the scarce resources.

The general rule for constrained resource allocation decisions with only one constraint is:
allocate scarce resources to products with the highest contribution margin per unit of the constrained resource, subject to qualitative considerations.

Constrained Resource Decisions (Multiple Scarce Resources) Usually managers face more than one constraint. Multiple constraints are easiest to analyze using a quantitative analysis technique known as linear programming. A problem formulated as a linear programming problem contains
an algebraic expression of the companys goal, known as the objective function
for example maximize total contribution margin or minimize total costs

a list of the constraints written as inequalities

Constrained Resource Decisions (Multiple Scarce Resources)


Urbane Co. produces two lines of hiking boots, Regular (Product R) and Deluxe (Product D). Pertinent information is shown below.
Sales price per unit Variable cost per unit Contribution margin per unit Machine time per unit (total available is 160,000 hours per period) Labor time per unit (total available is 600,000 hours per period) Product R $ 90 $ 70 $ 20 0.4 hours 2.0 hours Product D $ 161 $ 95 $ 66 2.0 hours 6.0 hours

Required: Recast the information given above in a linear programming format, including (a) the objective function, assuming that the firm aims to maximize its total contribution margin, and (b) the set of constraints.

Constrained Resource Decisions (Two Products; Two Scarce Resources)


Max OI = 20R + 66D - F subject to: .4R+2D 160,000 2R+6D 600,000 mach hr constraint DLH constraint

Graph these relationships,putting Product D On the vertical axis.


Sales price per unit Variable cost per unit Contribution margin per unit Machine time per unit (total available is 160,000 hours per period) Labor time per unit (total available is 600,000 hours per period) Product R $ 90 $ 70 $ 20 0.4 hours 2.0 hours Product D $ 161 $ 95 $ 66 2.0 hours 6.0 hours

Constrained Resource Decisions (Two Products; Two Scarce Resources)


0.4R+2D 160,000 Machine hr constraint 2R+6D 600,000 Direct labor hr constraint
Product R $ 90 $ 70 $ 20 0.4 hours 2.0 hours Product D $ 161 $ 95 $ 66 2.0 hours 6.0 hours

D 100,000 80,000

Sales price per unit Variable cost per unit Contribution margin per unit Machine time per unit (total available is 160,000 hours per period) Labor time per unit (total available is 600,000 hours per period)

R
300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


There are not enough machine hours or enough direct labor hours for this production plan. There are enough direct labor hours, but not enough machine hours, for this production plan. There are enough machine hours, but not enough direct labor hours, for this production plan. This production plan is feasible; there are enough machine hours and enough direct labor hours for this plan. The feasible set is the area where all the production constraints are satisfied.

D 100,000 80,000

R
300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


How do we know which of the feasible plans is optimal? We cant use the general rule for one-constraint problems. We can graph the total contribution margin line, because its slope will help us determine the optimal production plan.
If the iso-profit line is very shallow. . . this would be the optimal production plan.

D 100,000 80,000

The objective maximize total contribution margin means that we choose a production plan so that the contribution margin is a large as possible, without leaving the feasible set.

R
300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


What if the slope of the total contribution margin line is higher (in absolute value terms) than the slope of the direct labor hour constraint?

D 100,000 80,000

If the iso-profit line is very steep. . then this would be the optimal production plan.

R
300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


What if the slope of the total contribution margin line is between the slopes of the two constraints?

D 100,000 80,000

. . then this would be the optimal production plan.

R
300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


The last 3 slides showed that the optimal production plan is always at a corner of the feasible set. This gives us an easy way to solve 2 product, 2 or more scarce resource problems.
R=0, D=80,000 The total contribution margin here is 0 x $20 + 80,000 x $66 = $5,280,000. R=?, D=? Find the intersection of the 2 constraints. R=300,000, D=0 The total contribution margin here is 300,000 x $20 + 0 x $66 = $6,000,000.

D 100,000 80,000

R
300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


By checking the total contribution margin at each corner of the feasible set (ignoring the origin), we can see that the optimal production plan is R=150,000, D=50,000.

Total CM = $5,280,000.

D 100,000 80,000
Total CM = $6,300,000.

50,000
Total CM = $6,000,000.

R
150,000 300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


0.4R+2D 160,000 mach hr constraint 2R+6D 600,000 DL hr constraint Suppose that additional machine hours are available at a premium price. How many additional hours could be used? What would be the resulting product mix? What would be the resulting total contribution margin? What would be the shadow price per machine hour?

D 100,000 80,000

R
300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


0.4R+2D 160,000 mach hr constraint 2R+6D 600,000 DL hr constraint Suppose that additional labor hours are available at a premium price. How many additional hours could be used? What would be the resulting product mix? What would be the resulting total contribution margin? What would be the shadow price per labor hour?

D 100,000 80,000

R
300,000 400,000

Constrained Resource Decisions (Two Products; Two Scarce Resources)


Assume that the firm is considering production of a third product, Product G, that uses the same types of labor and equipment as do Products R and D. Each unit of Product G requires two machine hours and three labor hours, and incurs variable costs of $60 per unit. Assuming that these two resources are constrained as shown in the previous slides, what is the minimum sales price per unit required for Product G?

Constrained Resource Decisions (Two Products; Two Scarce Resources)


Assume that the firm is considering production of a third product, Product G, that uses the same types of labor and equipment as do Products R and D. Each unit of Product G requires two machine hours and three labor hours, and incurs variable costs of $60 per unit. Assuming that these two resources are constrained as shown in the previous slides, what is the minimum sales price per unit required for Product G? Approach: The sales price of Product G must cover its variable costs of production, and also the opportunity costs (or shadow prices) of the scarce resources (labor and machine time) required for its production. Minimum sales price = variable costs + opportunity costs.

Handout 4(a): Special Order Decisions

Rotunda, Inc. makes muffin fans for desktop computers. The normal selling price is $45.00 per unit. Rotunda was approached by a large computer manufacturer, Updraft, Inc. Updraft wants to buy 10,000 units at $32, and will pay the shipping costs. The per-unit costs traceable to the product (based on expected output of 100,000 units) are listed below. Which costs are relevant to this decision?

Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Shipping/handling Fixed administrative costs Fixed selling costs

$8.00 12.00 9.00 3.50 3.00 2.00 1.00 $38.50

The direct materials, direct labor and variable overhead are relevant. The per-unit total variable cost is $29 ($8 + 12 + 9 = $29)

Rotunda, Inc. makes muffin fans for desktop computers. The normal selling price is $45.00 per unit. Rotunda was approached by a large computer manufacturer, Updraft, Inc. Updraft wants to buy 10,000 units at $32, and will pay the shipping costs. The per-unit costs traceable to the product (based on expected output of 100,000 units) are listed below. Which costs are relevant to this decision?

Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Shipping/handling Fixed administrative costs Fixed selling costs

$8.00 12.00 9.00 3.50 3.00 2.00 1.00 $38.50

The direct materials, direct labor and variable overhead are relevant. The per-unit total variable cost is $29 ($8 + 12 + 9 = $29)

Required: 1. Suppose that the capacity of Rotunda is 120,000 units and projected sales to regular customers this year total 100,000 units. Does the quantitative analysis suggest that the company should accept the special order?

Rotunda, Inc. makes muffin fans for desktop computers. The normal selling price is $45.00 per unit. Rotunda was approached by a large computer manufacturer, Updraft, Inc. Updraft wants to buy 10,000 units at $32, and will pay the shipping costs. The per-unit costs traceable to the product (based on expected output of 100,000 units) are listed below. Which costs are relevant to this decision?

Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Shipping/handling Fixed administrative costs Fixed selling costs

$8.00 12.00 9.00 3.50 3.00 2.00 1.00 $38.50

The direct materials, direct labor and variable overhead are relevant. The per-unit total variable cost is $29 ($8 + 12 + 9 = $29)

Required: 1. Suppose that the capacity of Rotunda is 120,000 units and projected sales to regular customers this year total 100,000 units. Does the quantitative analysis suggest that the company should accept the special order?

Each unit sold to Updraft will increase Rotundas profits by $3 ($32 sales price less $29 variable unit cost), for a total increase in profits of $30,000 ($3 x 10,000 units).

2. Suppose instead that the capacity of Rotunda is 105,000 units and projected sales to regular customers this year total 100,000 units. Does the quantitative analysis suggest that the company should accept the special order? If not, what is the minimum price per unit that Rotunda could accept for an order of 10,000 units, without a reduction in profits?

2. Suppose instead that the capacity of Rotunda is 105,000 units and projected sales to regular customers this year total 100,000 units. Does the quantitative analysis suggest that the company should accept the special order? If not, what is the minimum price per unit that Rotunda could accept for an order of 10,000 units, without a reduction in profits?

In this case, acceptance of the special order (in full) would displace regular sales of 5,000 units and cause a decrease in total contribution margin of $35,000: Benefit from special order if no capacity constraint: $30,000 Reduction in profits from loss of 5,000 regular sales with a per-unit contribution of $13 ($45 32): ($65,000) Net: ($35,000)

2. Suppose instead that the capacity of Rotunda is 105,000 units and projected sales to regular customers this year total 100,000 units. Does the quantitative analysis suggest that the company should accept the special order? If not, what is the minimum price per unit that Rotunda could accept for an order of 10,000 units, without a reduction in profits?

In this case, acceptance of the special order (in full) would displace regular sales of 5,000 units and cause a decrease in total contribution margin of $35,000: Benefit from special order if no capacity constraint: $30,000 Reduction in profits from loss of 5,000 regular sales with a per-unit contribution of $13 ($45 32): ($65,000) Net: ($35,000) Alternative calculation: Revenues: Increase, special order sales,10,000 units $320,000 Decrease, lost regular sales, 5,000 units (225,000) Costs: Increase, 5,000 units @ $29 (145,000) Decrease, shipping costs saved, $3 per unit 15,000 Net effect (loss) ($35,000)
Note that if the special order revenues could be increased by a total of $35,000, or by $3.50 per unit, Rotunda would be equally profitable with or without the special order.

Handout 4(b): Drop or Keep Business Segment

Clock, Inc. has 3 divisions. The Hickory and Dickory Divisions have recently been operating at a loss. Management is considering the elimination of these divisions. Divisional income statements are given below. According to the quantitative analysis, should Clock eliminate Hickory or Dickory or both?

Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income

Hickory Dickory $500 $600 320 460 180 140 240 170 ($60) ($30)

Dock $900 500 400 200 $200

Total $2,000 1,280 720 610 $110 50 $60

Breakdown of traceable fixed costs: Avoidable $200 Unavoidable 40 $240

$120 50 $170

$160 40 $200

Clock, Inc. has 3 divisions. The Hickory and Dickory Divisions have recently been operating at a loss. Management is considering the elimination of these divisions. Divisional income statements are given below. According to the quantitative analysis, should Clock eliminate Hickory or Dickory or both?
Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Hickory Dickory $500 $600 320 460 180 140 240 170 ($60) ($30) Dock $900 500 400 200 $200 Total $2,000 1,280 720 610 $110 50 $60

Breakdown of traceable fixed costs: Avoidable $200 Unavoidable 40 $240

$120 50 $170

$160 40 $200

Hickorys avoidable fixed costs exceed the divisions contribution margin, so profits will increase by $20,000 if this division is dropped. Dickorys contribution margin exceeds its avoidable fixed costs, so the division should be retained. Note that after Hickory is dropped, the divisions unavoidable fixed costs will continue, and will be included in Clocks unallocated fixed costs.

Suppose that the Hickory and Dickory Divisions use the same supplier for a particular production input. If the Hickory Division is dropped, the decrease in purchases from this supplier means that Dickory will no longer receive volume discounts on this input. This will increase the costs of production for Dickory by $32,000 per year. In this scenario, should Clock still eliminate the Hickory Division?

Suppose that the Hickory and Dickory Divisions use the same supplier for a particular production input. If the Hickory Division is dropped, the decrease in purchases from this supplier means that Dickory will no longer receive volume discounts on this input. This will increase the costs of production for Dickory by $32,000 per year. In this scenario, should Clock still eliminate the Hickory Division?

Hickory should be retained because the increase in production cost of $32,000 exceeds the $20,000 gain from shutting down the division.
Hickory Dickory $500 $600 320 460 180 140 240 170 ($60) ($30) Dock $900 500 400 200 $200 Total $2,000 1,280 720 610 $110 50 $60

Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income

Breakdown of traceable fixed costs: Avoidable $200 Unavoidable 40 $240

$120 50 $170

$160 40 $200

Handout 4(c): Multi-Product Profit Maximization

Two products, one constraint: Arcane Products provides the following revenue and cost information for its two products, Product P and Product H: Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700 Questions: 1. Write out the profit-volume equation for Arcane Products. OI = 120P + 90H 2,700

1. Solve the profit-volume equation for Product H. H = (2,700 + OI) / 90 (120 / 90) P 2. Draw a graph of this equation (with units of Product H on the vertical axis).
(2700 + OI) / 90 H Slope = -120/90

Determine the optimum production level for Products P and H. H earns the highest return per material pound used, therefore the company should produce 60 units of H and zero P.
Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700

1. Determine the value (opportunity cost, or shadow price) of material per pound. $ 90

2. Write out the materials constraint as a linear equation (in this case, as a < inequality). Solve the constraint equation for product H. 2P + 1H < 60; H < 60 2P

3. Include a line to represent the materials constraint on the graph prepared in question 3 above.
H
Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700

Slope = -2

(2700 + OI) / 90 Slope = -120/90

1. Holding the price of Product H constant, by what amount would the sales price of Product P have to change in order for the firm to be indifferent between production of products P and H?

Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700

1. Holding the price of Product H constant, by what amount would the sales price of Product P have to change in order for the firm to be indifferent between production of products P and H? Variable cost of P plus opportunity cost of the two pounds of material removed from H: $260 (VC of $80 + 2 x $90)

Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700

1. Holding the price of Product H constant, by what amount would the sales price of Product P have to change in order for the firm to be indifferent between production of products P and H? Variable cost of P plus opportunity cost of the two pounds of material removed from H: $260 (VC of $80 + 2 x $90) 2. Holding the price of Product P constant, by what amount would the sales price of Product H have to change in order for the firm to be indifferent between production of products P and H?

Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700

1. Holding the price of Product H constant, by what amount would the sales price of Product P have to change in order for the firm to be indifferent between production of products P and H? Variable cost of P plus opportunity cost of the two pounds of material removed from H: $260 (VC of $80 + 2 x $90) 2. Holding the price of Product P constant, by what amount would the sales price of Product H have to change in order for the firm to be indifferent between production of products P and H? Variable cost of H plus opportunity cost of the pound of material removed from P: $140 (VC of $80 + $60)

Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700

1. Holding the price of Product H constant, by what amount would the sales price of Product P have to change in order for the firm to be indifferent between production of products P and H? Variable cost of P plus opportunity cost of the two pounds of material removed from H: $260 (VC of $80 + 2 x $90) 2. Holding the price of Product P constant, by what amount would the sales price of Product H have to change in order for the firm to be indifferent between production of products P and H? Variable cost of H plus opportunity cost of the pound of material removed from P: $140 (VC of $80 + $60) 3. Holding the prices of products P and H constant, assume that a third product, Product T, may also be produced in the same facility as Products H and P. Product T has variable production costs of $ 50 per unit, and requires 1.5 pounds of material. What is the minimum required sales price per unit of Product T, in order not to reduce the firms total profit?

Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700

1. Holding the price of Product H constant, by what amount would the sales price of Product P have to change in order for the firm to be indifferent between production of products P and H? Variable cost of P plus opportunity cost of the two pounds of material removed from H: $260 (VC of $80 + 2 x $90) 2. Holding the price of Product P constant, by what amount would the sales price of Product H have to change in order for the firm to be indifferent between production of products P and H? Variable cost of H plus opportunity cost of the pound of material removed from P: $140 (VC of $80 + $60) 3. Holding the prices of products P and H constant, assume that a third product, Product T, may also be produced in the same facility as Products H and P. Product T has variable production costs of $ 50 per unit, and requires 1.5 pounds of material. What is the minimum required sales price per unit of Product T, in order not to reduce the firms total profit? Variable cost of T plus opportunity cost of the 1.5 pounds of material removed from H: $185 (VC of $50 + 1.5 x $90)
Product P Product H Sales price $200 $170 Variable cost $ 80 $ 80 Contribution margin $120 $ 90 Material per unit 2 lbs. 1 lb. Total material pounds available: 60 lbs. Total fixed manufacturing costs: $ 2,700

Two products, multiple constraints: In addition to the information above, you now learn that Arcane Products uses skilled labor in its products. The skilled labor is in short supply, and a maximum of 120 hours is available in each period. Each unit of Product P requires two hours, and each unit of Product H requires three hours, of skilled labor. In addition, the maximum amount of Product P that can be sold is 45 units per period. Questions: 1. Write out the skilled labor constraint as a linear equation (in this case, as a < inequality). 2P + 3H < 120 2. Include a line to represent the skilled labor constraint on the graph prepared above. (See below) 3. Include a line to represent the market size constraint on the graph prepared above. (See below) 4. Determine the optimum production level for Products P and H.

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

60

40 30

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

22.5

30

45

60

60

40 30

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

22.5

30

45

60

60

40 30

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

22.5

30

45

60

60

40 30

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

22.5

30

45

60

60

Market size P<45

40 30

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

22.5

30

45

60

60

Market size P<45

40 30
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

22.5

30

45

60

60

Market size P<45

40 30
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

60

Market size P<45

40 30
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

60

Material 2P+1H<60

Market size P<45

40 30
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

60

Material 2P+1H<60 H<60-2(P)

Market size P<45

40 30
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

60

Material 2P+1H<60 H<60-2(P)

Market size P<45

40 30
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

60

Material 2P+1H<60 H<60-2(P)

Market size P<45

40 30
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

60

Material 2P+1H<60 H<60-2(P)

Market size P<45

40 (P=15, H=30) 30
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

Relaxing a constraint: impact on optimal product mix (one product increases, the other decreases, because the constraints have negative slopes).

Relaxing a constraint: impact on optimal product mix (one product increases, the other decreases, because the constraints have negative slopes).

2 1

Relaxing a constraint: impact on optimal product mix (one product increases, the other decreases, because the constraints have negative slopes).

3 2 1

60

Material 2P+1H<60 H<60-2(P)

Market size P<45

40 30

Assume that you are able to acquire additional labor at a premium price. How much labor would you be willing to hire, and how much of a price premium would you be willing to pay? What would be your new product mix and total contribution margin? (P=15, H=30)
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

Shifts in the profit line as the product on the horizontal axis becomes less profitable.

Shifts in the profit line as the product on the horizontal axis becomes less profitable.

2 1

Shifts in the profit line as the product on the horizontal axis becomes less profitable.

2 1

60

Material 2P+1H<60 H<60-2(P)

Market size P<45

40 30

Assume that your product contribution margins have been estimated statistically, and you need to evaluate the impact of estimation errors. By what amount could the contribution of product H be different, before the optimum product mix shown here would be less than optimal? (P=15, H=30)
Skilled labor 2P+3H<120

OI=90H+120P-2,700 H=(2,700+OI)/90 -(120/90)P H=30-(120/90)(P)

H<40-2/3(P)

22.5

30

45

60

Linear programming problems generally entail many more activities (e.g. products) and constraints than the simple example that we have just reviewed. Many dedicated programs are available for the solution of larger-scale and more realistic decisions. A very friendly (easy-to-use) program available at UMass is LINDO. The following slides illustrate the formulation and solution of our example problem using LINDO. Note that In addition to solving for the optimal product mix, the available output includes extensive sensitivity analysis that permits you to evaluate the potential impacts of errors in the management accounting measurements that are imbedded in the formulation of the problem.

Formulation of a product mix problem in LINDO:

max

120p+90h
st 2p+1h<60

2p+3h<120
p<45 end

Material Labor Market

Material Labor Market

Handout 4(d): Relevant Costs Multiple-choice items

1. Gandy Company has 5,000 obsolete desk lamps that are carried in inventory at a manufacturing cost of $50,000. If the lamps are reworked for $20,000, they could be sold for $35,000. Alternatively, the lamps could be sold for $8,000 for scrap. In a decision model analyzing these alternatives, the sunk cost would be: A. $8,000 B. $15,000 C. $20,000 D. $50,000

1. Gandy Company has 5,000 obsolete desk lamps that are carried in inventory at a manufacturing cost of $50,000. If the lamps are reworked for $20,000, they could be sold for $35,000. Alternatively, the lamps could be sold for $8,000 for scrap. In a decision model analyzing these alternatives, the sunk cost would be: A. $8,000 B. $15,000 C. $20,000 Additional questions: If the lamps are sold D. $50,000
for scrap, what is the opportunity cost? What is the opportunity loss?

2. Hodge Inc. has some material that originally cost $74,600. The material has a scrap value of $57,400 as is, but if reworked at a cost of $1,500, it could be sold for $54,400. What would be the incremental effect on the company's overall profit of reworking and selling the material rather than selling it as is as scrap? A. -$79,100 B. -$21,700 C. -$4,500 D. $52,900

2. Hodge Inc. has some material that originally cost $74,600. The material has a scrap value of $57,400 as is, but if reworked at a cost of $1,500, it could be sold for $54,400. What would be the incremental effect on the company's overall profit of reworking and selling the material rather than selling it as is as scrap? A. -$79,100 B. -$21,700 The net realizable value from rework is C. -$4,500 $52,900 ($54,400 - $1,500). This is D. $52,900 $4,500 below the proceeds from scrap
sale ($57,400 - $52,900 = $4,500).

3. Rice Corporation currently operates two divisions which had operating results last year as follows:

Since the Troy Division also sustained an operating loss in the prior year, Rice's president is considering the elimination of this division. Troy Division's traceable fixed costs could be avoided if the division were eliminated. The total common corporate costs would be unaffected by the decision. If the Troy Division had been eliminated at the beginning of last year, Rice Corporation's operating income for last year would have been: A. $15,000 higher B. $30,000 lower C. $45,000 lower D. $60,000 higher

3. Rice Corporation currently operates two divisions which had operating results last year as follows:

Since the Troy Division also sustained an operating loss in the prior year, Rice's president is considering the elimination of this division. Troy Division's traceable fixed costs could be avoided if the division were eliminated. The total common corporate costs would be unaffected by the decision. If the Troy Division had been eliminated at the beginning of last year, Rice Corporation's operating income for last year would have been: A. $15,000 higher B. $30,000 lower Dropping the Troy Division would reduce contribution C. $45,000 lower margin by $100,000 and fixed costs by $70,000 for a D. $60,000 higher

net decrease in operating income of $30,000.

4. Beaver Company (a multi-product firm) produces 5,000 units of Product X each year. Each unit of Product X sells for $8 and has a contribution margin of $5. If Product X is discontinued, $18,000 of fixed overhead would be eliminated. As a result of discontinuing Product X, the company's overall operating income would: A. decrease by $25,000 B. increase by $43,000 C. decrease by $7,000 D. increase by $7,000

4. Beaver Company (a multi-product firm) produces 5,000 units of Product X each year. Each unit of Product X sells for $8 and has a contribution margin of $5. If Product X is discontinued, $18,000 of fixed overhead would be eliminated. As a result of discontinuing Product X, the company's overall operating income would: A. decrease by $25,000 B. increase by $43,000 C. decrease by $7,000 Dropping Product X would D. increase by $7,000

decrease contribution margin by $25,000 and reduce fixed costs by $18,000, for a net income decrease of $7,000.

5. Milli Company plans to discontinue a division that generates a total contribution margin of $20,000 per year. Fixed overhead associated with this division is $50,000, of which $5,000 cannot be eliminated. The effect of this discontinuance on Milli's operating income would be an increase of: A. $5,000 B. $20,000 C. $25,000 D. $30,000

5. Milli Company plans to discontinue a division that generates a total contribution margin of $20,000 per year. Fixed overhead associated with this division is $50,000, of which $5,000 cannot be eliminated. The effect of this discontinuance on Milli's operating income would be an increase of: A. $5,000 B. $20,000 Closing the division would reduce contribution margin by C. $25,000 $20,000 and reduce fixed costs D. $30,000
by $45,000, for a total increase of $25,000 in operating income.

6. Supler Company produces a part used in the manufacture of one of its products. The unit product cost is $18, computed as follows:

An outside supplier has offered to provide the annual requirement of 4,000 of the parts for only $14 each. It is estimated that 60 percent of the fixed overhead cost above could be eliminated if the parts are purchased from the outside supplier. Based on these data, the per-unit dollar advantage or disadvantage of purchasing from the outside supplier would be: A. $1 disadvantage B. $1 advantage C. $2 advantage D. $4 disadvantage

6. Supler Company produces a part used in the manufacture of one of its products. The unit product cost is $18, computed as follows:

An outside supplier has offered to provide the annual requirement of 4,000 of the parts for only $14 each. It is estimated that 60 percent of the fixed overhead cost above could be eliminated if the parts are purchased from the outside supplier. Based on these data, the per-unit dollar advantage or disadvantage of purchasing from the outside supplier would be: A. $1 disadvantage Purchasing from the outside supplier B. $1 advantage C. $2 advantage at $14 per unit would avoid costs per D. $4 disadvantage

unit of $16 ($13 variable unit costs and $3 avoidable fixed costs.

7. Holden Company produces three products, with costs and selling prices as follows:

A particular machine is a bottleneck. On that machine, 3 machine hours are required to produce each unit of Product A, 1 hour is required to produce each unit of Product B, and 2 hours are required to produce each unit of Product C. In which order should it produce its products? A. C, A, B B. A, C, B C. B, C, A D. The order of production doesn't matter.

7. Holden Company produces three products, with costs and selling prices as follows:

A particular machine is a bottleneck. On that machine, 3 machine hours are required to produce each unit of Product A, 1 hour is required to produce each unit of Product B, and 2 hours are required to produce each unit of Product C. In which order should it produce its products? The products should be A. C, A, B B. A, C, B produced in the order of their C. B, C, A D. The order of production doesn't matter. contribution per machine

hour.The contribution per machine hour is $4 for Product A, $5 for Product B and $4.50 for Product C. The ordering should be B, C and A.

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